Transfer Pricing Developments

Transfer pricing issues continue to be an important focus for multinational enterprises (“MNEs”) and tax authorities.  This post summarizes some of the significant developments in Canada that have arisen so far in 2016 and what to look forward to in the coming months.  In particular, we highlight a decision of the Federal Court of Appeal, Canada’s implementation of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan and some significant transfer pricing cases that are working their way through the Tax Court of Canada.

Marzen Artistic Aluminum Ltd. v. The Queen – Federal Court of Appeal

The only significant transfer pricing decision in the Canadian courts in 2016, to date, is Marzen Artistic Aluminum Ltd. v. The Queen (2016 DTC 5018).  The Federal Court of Appeal dismissed the taxpayer’s appeal of the 2014 Tax Court judgment that accepted the transfer pricing adjustments and penalties assessed by the Minister of National Revenue (the “Minister”) in respect of transactions between the Canadian corporate taxpayer and its wholly owned Barbados subsidiary, Starline International Inc. (“SII”).[1]

The first issue considered by the Tax Court was whether the Marketing and Sales Services Agreement (“MSSA”) entered into between the taxpayer and SII, differed from what would have been agreed to by parties dealing at arm’s length.  The taxpayer had deducted $4.2 million and $7.8 million for fees paid to SII in 2000 and 2001, respectively.  SII used these fees, in part, to pay the taxpayer’s U.S. subsidiary (“SWI”) for services provided under a Personnel Secondment Agreement and an Administrative and Support Services Agreement.  The payments from SII to SWI were $2.1 million and $2.8 million in 2000 and 2001, respectively.  The Tax Court determined that the MSSA did not conform with the arm’s length principle and, therefore, the Minister was permitted to make an adjustment to the taxpayer’s income pursuant to paragraph 247(2)(a) of the Income Tax Act (Canada) (the “Act”).[2]  The Tax Court also made a determination of the amount that arm’s length parties would have paid for the services provided under the MSSA, in accordance with paragraph 247(2)(c).  The Tax Court relied on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “OECD Guidelines”) to adopt the Comparable Uncontrolled Price (“CUP”) method as the appropriate method to determine the arm’s length price for the services provided by SII to the taxpayer.  Further, the Tax Court accepted the Minister’s position that the portion of the fees that related to amounts paid by SII to SWI reflected the arm’s length principle.  Based on its finding that an arm’s-length Barbados-resident consultant had provided services to SII and SWI that were comparable to the services provided to the taxpayer under the MSSA, the Tax Court concluded that the annual fee paid by SII to the Barbados consultant (US$32,250) was a CUP for the transactions between the taxpayer and SII under the MSSA.  On this basis, the court ordered the Minister to slightly modify the reassessments of the taxpayer under paragraphs 247(2)(a) and (c) so that the Minister’s original increase to the taxpayer’s income was reduced by allowing the taxpayer to deduct an additional US$32,250 in excess of the amounts paid by SII to SWI for each of its 2000 and 2001 taxation years.  The Tax Court confirmed the Minister’s application of the transfer pricing penalties under subsection 247(3) in an amount exceeding $500,000 for the 2001 taxation year, representing 10% of the transfer pricing adjustment for that year.

At the Federal Court of Appeal, Scott JA (for the unanimous court) stated that the issue to be decided was “fundamentally whether the Judge erred in her application of the principle outlined in paragraphs 247(2)(a) and (c) of the Act and more precisely, whether the Judge identified the proper transaction and took into account the appropriate related party contract prices.”[3]

In essence, the Federal Court of Appeal concluded that the trial judge had sufficient evidence before her to reach the conclusions she did about whether the transaction between the taxpayer and SII would have been entered into by arm’s length parties and she did not err by basing her finding on the OECD Guidelines. The Federal Court of Appeal noted that the Supreme Court of Canada in Canada v. GlaxoSmithKline[4] affirmed that a transfer pricing analysis is “inherently fact driven” and that while the OECD Guidelines are not determinative in the same way as a statute, they are “useful” in determining what a reasonable business person would have paid if he or she was party to the transaction in question.[5]

The taxpayer’s failure at trial to demolish the Minister’s assumptions in the assessment seem to be fundamental to the outcome of the appeal. In particular, the taxpayer’s expert report failed to persuade the trial judge that SWI and SII should be treated as a single operating entity and thus justify higher fees payable by the taxpayer under the MSSA.  The Court held that the trial judge was correct in separating the roles of SII and SWI in order to apply the arm’s length principle, particularly in light of the contractual provisions in the agreements between SII and SWI which made it clear that these entities were to operate separately and not in partnership or as a joint venture.  The Court also concluded that it was open to the trial judge to adopt the CUP methodology favoured by the OECD Guidelines in determining the appropriate transfer pricing in spite of the taxpayer’s expert report which preferred the transactional net margin method (or TNMM).  Furthermore, absent an overriding and palpable error in trial judge’s appreciation of the evidence supporting the use of the CUP method, the Federal Court of Appeal refused to overturn the trial judge’s finding that the arm’s length Barbados consultant’s services were comparable to the services under the MSSA.

The imposition of penalties under subsection 247(3) was not challenged by the taxpayer on appeal.

The outcome of this appeal emphasizes the importance of clear, well thought-out commercial agreements to document transactions between the related parties and strong contemporaneous documentation which apply methodologies (preferably, in accordance with the OECD Guidelines) in support of the transfer prices used. The decision in this case also highlights the inherently fact-based nature of transfer pricing appeals which necessitates persuasive expert evidence.

Proposed Section 233.8 – Country-by-Country Report

On March 22, 2016, the Minister of Finance tabled the federal budget (“Federal Budget”) that confirmed Canada’s commitment to move forward with a number of initiatives to address the OECD’s base erosion and profit shifting (“BEPS”) project.

In order to “improve the integrity of Canada’s international tax system”, the Federal Budget announced forthcoming new legislation to “strengthen transfer pricing documentation”.[6]  On July 29, 2016, proposed section 233.8 was released which provides the details about how country-by-country reporting for large MNEs will apply in Canada.  These proposed changes arise from the OECD final report relating to Action 13 of the OECD BEPS Action Plan – “Guidance on Transfer Pricing Documentation and Country-by-Country Reporting”.

The country-by-country report is a form that an MNE with annual consolidated group revenue of €750 million or more will be required to file with the tax authority for the country in which the group’s “ultimate parent entity” resides.  Ultimate parent entity is generally defined as a constituent entity of an MNE group that holds directly or indirectly a sufficient interest in one or more constituent entities of the MNE group so that it is required to prepare consolidated financial statement under accounting principles generally applied in its jurisdiction of residence, or would be so required if its equity interests were traded on a public securities exchange in its jurisdiction of residence.  Special deeming rules apply where the ultimate parent entity is a partnership. Generally, a “constituent entity” of an MNE group means a business entity that is included in the consolidated financial statements for financial reporting purposes but also includes entities that are excluded from the consolidated financial statements solely for size or materiality reasons.

Proposed subsection 233.8(3) provides that a report, in a form prescribed by the Minister, will be required to be filed in the prescribed manner, together with each substantially similar report required to be filed in a jurisdiction other than Canada (collectively, a “country-by-country report”), by the ultimate parent entity, if it a resident of Canada, or by a constituent member of the MNE that is resident in Canada, if one of the following conditions applies: (A) the ultimate parent entity of the MNE group is not obligated to file a country-by-country report in its jurisdiction of residence, (B) the jurisdiction of residence of the ultimate parent entity of the MNE group does not have a “qualifying competent authority agreement” with Canada; or (C) there has been a “systemic failure” of the jurisdiction of residence of the ultimate parent entity and the Minister has notified the constituent entity of the systemic failure.

For these purposes, a “qualifying competent authority agreement” is an agreement between authorized representatives of those jurisdictions that are parties to the Convention on Mutual Administrative Assistance in Tax Matters or a comprehensive tax information exchange agreement (“TIEA”) with Canada, that mandates automatic exchange of country-by-country reports. A “systemic failure” means, with respect to a jurisdiction, that the jurisdiction has a qualifying competent authority agreement with Canada but has suspended automatic exchange for reasons outside those permitted by such agreement, or has persistently failed to automatically provide to Canada country-by-country reports in its possession that related to MNE group with Canadian resident members.

Where an MNE group has more than one Canadian constituent member, proposed subsection 233.8(4) allows for one of the Canadian members to be designated by the MNE group to file a country-by-country report on behalf of the other constituent members. Furthermore, proposed subsection 233.8(5) allows for a constituent member of the MNE group to file the country-by-country report instead of the ultimate parent entity (a “surrogate parent entity”).  However, certain requirements relating to the jurisdiction of the surrogate parent entity must be met in order to relieve the Canadian-resident constituent members of the obligation to file the country-by-country report under subsection 233.8(3) including a qualifying competent authority agreement with such jurisdiction must be in effect.

The report itself includes the global allocation, by country of revenue, profit, tax paid, stated capital, accumulated earnings, employees, tangible assets and descriptions of the main activities of each constituent member of the MNE.[7]

Proposed subsection 233.8(6) provides that a country-by-country report in respect of a “reporting fiscal year” of an MNE group must be filed on before the later of (a) 30 days following the constituent’s receipt of a notification of a systemic failure, if applicable, or (b) 12 months after the last day of the reporting fiscal year. For these purposes, a “fiscal year” of an MNE group is the annual accounting period with respect to which the ultimate parent entity prepares its financial statements.  The “reporting fiscal year” means a fiscal year, if the financial and operational results of the fiscal year are reflected in the country-by-country report.

When enacted, new section 233.8 will apply to reporting fiscal years of MNE groups that begin on or after January 1, 2016. This means that the first country-by-country reports for MNEs with a calendar fiscal year should be filed in Canada no later than December 31st, 2017.

The July 29th, 2016 draft legislation also contains amendments to the penalty provisions in subsection 162(10) to now include a failure to file a country-by-country report under section 233.8.

Revised Transfer Pricing Guidance

The Federal Budget also included comments about certain OECD BEPS recommendations regarding revisions to the OECD Guidelines. In particular, it was noted that final report of the OECD BEPS Action Plan, items 8 to 10 “Aligning Transfer Pricing Outcomes with Value Creation”, proposes revisions to the OECD Guidelines which “provide improved interpretation of the arm’s length principle”.  According to the Federal Budget, these revisions are in line with the interpretations of the Canada Revenue Agency (“CRA”) as reflected in its current auditing and assessing practices and are being applied in Canada already.

The Federal Budget noted that there were two areas of proposed revision to the OECD Guidelines that are provided for in the OECD BEPS final report where certain “follow-up work” was not yet completed. Firstly, revisions were proposed to develop a threshold for a simplified approach to low value-adding services.  Second, the OECD proposed revisions to clarify the definition of risk-free and risk-adjusted returns for minimally functional entities, which tax authorities sometimes refer to as “cash boxes”.  These two areas are among the most controversial of the changes to the OECD Guidelines and have been heavily criticized.[8]  The Federal Budget stated that Canada will decide how to deal with these matters once the OECD working group has completed its follow-up work.

On May 23, 2016, the OECD Council approved the amendments to the OECD Guidelines as recommended in the final report of the OECD BEPS Action Plan, items 8 to 10. While the announcement of this approval only mentioned further work being undertaken to make conforming amendments to Chapter IX of OECD Guidelines relating to “Transfer Pricing Aspects of Business Restructurings”, the final report itself contemplates the follow-up work required that Canada is waiting on.  Once this work is completed, Canada should indicate its position on these controversial amendments to the OECD Guidelines in due course.

Coming Soon

There are a number of transfer pricing cases currently working their way through the Tax Court of Canada including the following:

  1. Sifto Canada Corp. v. The Queen. This case involves transfer pricing of rock salt. The trial in the Tax Court of Canada was heard during the week of July 18, 2016 and judgment was reserved. This case is also the subject of a judicial review application.[9]
  2. Cameco Corporation v. The Queen. This high profile transfer pricing case involves the sale of uranium by Cameco Corporation to its Swiss affiliate, Cameco Europe Ltd. and has been proceeding since 2009. The trial commences on October 4, 2016 and is scheduled to last months.
  3. Silver Wheaton Corp. v. The Queen. The Notice of Appeal for this case was filed in January, 2016 and relates to transfer pricing on transactions between Silver Wheaton and its subsidiary in the Cayman Islands.
  4. Conoco Funding Company v. The Queen/ Burlington Resources Finance Company v. The Queen. These ongoing and similar issue cases concern transfer pricing for guarantee fees paid by a Canadian corporate taxpayer to its non-resident parent corporation. In June 2016, the Tax Court heard the Crown’s motion for answers to discovery questions and reserved judgment.

[1]      See Wong, Andrew, “Marzen Artistic Aluminum Ltd. v. The Queen: How Far Does “Proof in the Pudding” Go?”, CCH International Tax Newsletter, Report 77, August 2014.

[2]      All statutory references herein are to the Act.

[3]      At para. 51.

[4]      [2012] 3 SCR 3.

[5]      At para. 18.

[6]      See Lewin, Richard “Country-by-Country Reporting, or Action 13, Huh Yeah What is it good for?”, CCH International Tax Newsletter, Report 87, May, 2016.

[7]      For more detail, see Mr. Lewin’s article, ibid.

[8]      See, for example, Nathan Boidman and Michael N. Kandev, ‘‘BEPS: A Spent Force or Radical Change?’’ Tax Notes International, Dec. 7, 2015, p. 837.

[9]      2014 FCA 140.


Christopher Steeves is the Leader of Fasken Martineau's Tax practice group and is based in Toronto.